• Introduction: A Nod to the Academics
  • Deleveraging & Excess Returns
  • How Debt Reduction Works
  • Valuation and Deleveraging, Enhancing Outcomes
  • Stock Issuance & Returns
  • Conclusion

Introduction: A Nod to the Academics

Encrusted in controversy, the work on capital structures begun by Franco Modigliani and Merton Miller in 1958 continues to garner the attention of investors and academics alike to this day. Much of the debate stems from their concept that, in an environment without bankruptcy, taxes or friction and with unlimited ability to arbitrage, capital should effectively be priced uniformly regardless of source or construction. Investors should be agnostic regarding the mix of equity and debt at the firm level in their world. Miller summed it up nicely in 1991 with his analogy:

Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring. (Selling cream is the analog of a firm selling debt securities, which pay a contractual return). But, of course, what the farmer would have left would be skim milk, with low butter-fat content, and that would sell for much less than whole milk. (Skim milk corresponds to the levered equity.) The Modigliani-Miller proposition says that if there were no cost of separation (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk.2, 3

The M&M Proposition has proven to be an intellectual keystone in an ever growing body of discussion and debate around the role of capital formation and corporate performance in the years since its publication. We make no attempt in this paper to engage in the granularity often associated with subsequent discussion of the authors’ work but feel obligated to bring the pair up as what follows will be an analysis of how changes in capital structure can be exploited to help improve stock selection. Most importantly, we hope our work provides a constructive venue for investors and managements to come together around a powerful yet simple step that may enhance firm value. With that said, we move forward with an analysis of skim milk!

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